Multi-factor models

Understanding both the level of, and the sources of, risk

Most traditional suppliers of market risk models for use by professional investment managers have developed linear multi-factor models.

Such models are suitable for use in asset management because they both estimate the level of market risk of an investment portfolio and also attribute that risk to its underlying sources. This makes it possible for the manager to confirm that they are adhering to an agreed or indicated level of risk and also that they are taking risk bets consistent with the mandate.

While no model of investment risk can ever be perfect, most risk model vendors would likely agree that the linear factor model has significant advantages over other approaches in being particularly useful for the management and understanding of investment portfolios. This comparative usefulness arises, in particular, from the ability to decompose the risk of a portfolio into a set of systematic risks separate from the idiosyncratic risk associated with each of the individual assets held.

For example, a simple risk analysis system could advise which of the assets held have been the most volatile. It could go a little further and group assets by category – country, sector or fundamental attribute, for example – and report on the categories that contain the most volatile assets.

The more sophisticated linear factor model based system can go one step further and take account of the price performance behaviour of each asset relative to all other assets to estimate which systematic effects – countries, sectors, fundamental attributes or other categories or macro effects – are the greatest source of likely risk.

As this analysis requires the modelling of the relationships between all the assets and between representations of each country, sector, fundamental attribute or other categories or macro effects – the modelling is non-trivial, especially taking account of the very large numbers of assets and attributes.

EMA has developed its models over more than twenty years to help the risk manager and the portfolio manager to obtain a deep comprehension of the drivers of portfolio risk.